Friday, March 6, 2009

Tranche Warfare: MBS Investor Sues American Home Over REO Sales

A Greenwich-based hedge fund manager is in a desperate fight to keep his subprime MBS investment strategy alive. HousingWire peeled back the layers to uncover what’s really going on behind the scenes in what has become a vicious battle between the hedge fund and legendary investor Wilbur Ross’ mortgage servicing company, Irving, Tex.-based American Home Mortgage Servicing, Inc.

The lawsuit underscores just how complicated servicing non-agency securitized loans can really be, amid a push by legislators and regulators to put a common set of standards into place to help manage a housing crisis that as of yet shows little signs of slowing down.

Bruce Rose, who runs hedge fund Carrington Investment Partners LP – and who purchased a mortgage servicing platform of his own last year when former subprime high-flier New Century Mortgage went bankrupt – filed a lawsuit last month claiming that American Home Mortgage Servicing, the nation’s largest independent mortgage servicer, had been selling the REO homes it manages at ‘fire sale prices,’ because it needed cash to pay off its warehouse credit facility.

The REO sales push was hurting Rose’s hedge fund, because the loans on the homes are tied to mortgage-backed securities Rose had invested in. According to Carrington investors and sources familiar with Rose’s investment strategy, the hedge fund owns the junior tranches of the deals in question.

Carrington, which leaked a copy of the lawsuit to the Wall Street Journal before the suit had been served to American Home Mortgage and filed in court, alleges in its complaint that AHMSI saw its core credit facilities shrunk, forcing the REO sales. But sources familiar with Irving-based servicer say they’ve never worried about being able to tap the credit market – and say that selling the REOs had nothing to do with paying down an existing credit facility.

Instead, AHMSI’s decision to sell the homes was driven out of a desire to serve the best interests of the trust that represents all investors, sources say – to get the most money they could for the trust, because holding on to properties while home prices remain in a negative freefall costs most bondholders more money than simply getting the properties off the books. Most servicers have a fiduciary duty to a trust to maximize net present value of cash flows to investors, per most traditional pooling and servicing agreements that bind servicer’s activities.

David Friedman, CEO of American Home Mortgage, told HousingWire today, “The financial health of our company is strong. We paid off the original credit facility and replaced it with an AAA-rated facility. In fact, if needed, we can expand our credit limit and others can now invest in our high quality debt.”

So-called ‘tranche warfare’ is something that most investors and servicers have become accustomed to, but the Carrington/AMHSI dispute is unique because of the structure of the specific deals Carrington invested in. According to the complaint, Carrington acquired a 100 percent interest in a unique class of subordinate certificates in various MBS deals during 2005 and 2006, totaling $128.1 million in principal amount.

These subordinate certificates allegedly give Carrington the right to direct the servicer over the management and sale of all REO properties tied to the trust, a right that Carrington asserts in the pleading it had bargained specifically for in structuring the deals – three of the four MBS deals in question were issued directly by Carrington. All four deals were serviced by Option One Mortgage Company until Ross’ AHMSI unit acquired the Option One platform last year from tax giant H&R Block (HRB: 18.68 +7.85%).

Carrington argues in the complaint that its interests as a junior bondholder are in line with those of the senior bondholders, as well as trustees including Deutsche Bank (DB: 23.36 -0.13%) and Wells Fargo & Co. (WFC: 8.61 +6.03%) – allegations that are being hotly contested by sources that spoke with HousingWire.

Holding REO hostage?

Rose is currently battling an investor-led lawsuit, filed early last year, for alleged securities fraud and breach of his duties as the manager of the hedge fund; his fund booked a negative 9.75 percent return for 2008, according to an investor letter reviewed by HousingWire. That return is actually amazingly good given the upheaval among most funds investing in private-party MBS – but according to the investors in the lawsuit, Rose is improperly marking the assets in the fund to his own model.

Carrington was also one of the first hedge funds to get investors to vote on an amendment halting redemptions in late 2007; according to the securities lawsuit against the fund, Rose said if he had to sell the subprime-backed mortgage securities he would only get 10 cents on the dollar and would have to shut down the fund. The attorney representing Carrington investors told HousingWire that they anticipate moving for summary judgment shortly after Rose finally answers the original complaint, which is due later this month; such a judgment could invalidate the redemption amendment, and leave Carrington’s fund open to significant redemptions.

Sean O’Shea, an attorney representing Carrington, said that Rose was acting to protect investors by preventing redemptions. “By putting up the gate, Rose acted in the interest of all his investors and upheld his duty to all,” he told HousingWire. O’Shea also stressed that the investors’ claims are baseless. Nonetheless, a Connecticut federal judge ruled last month that the Carrington investors’ complaint had strong enough evidence to move forward with the securities fraud claim.

Rose allegedly told a fellow top hedge fund manager in 2007 that his strategy was to “isolate and hold the credit risk on subprime deals,” a strategy borne out by the unique class of securities Carrington now holds on the AMHSI-serviced loans. A hedge fund manager who knows Rose and spoke on the condition of anonymity told HousingWire, “I’d be amazed if there was actually any money left in the fund.”

How much money is left remains to be seen; but the special rights allegedly given to Carrington as a junior bondholder in the disputed loans have apparently led to some strange behavior, including allegedly attempting to direct AHMSI not to sell its REO properties, or to list them above market value to ensure they do not sell. When a loan in the pool does default, as long as the servicer still holds on to the property as a bank owned asset and marks it at the level of the original loan investment, the junior bond continues to pay out, sources told HousingWire.

In contrast, if the REO property is sold and actual market prices are recognized, the junior tranche would effectively be wiped out while the senior tranches divide up the recovered principal. So by dictating how a servicer can manage the loan, Carrington could control the value of its investment while setting up senior bondholders for a fall they may or may not have expected. Sources familiar with the situation told HousingWire that Rose has been asking AHMSI to book the REO in its deals at a mark-to-model method he prefers, rather than using independent appraisals or other common methods of property valuation.

Sources familiar with the situation also suggested that Rose originally attempted to get the trustees on the deals – Deutsche and Wells Fargo – to fire AHMSI as servicer of record, a move that led the trustees to suggest they poll all other investor classes first. When it became clear that other investors were unwilling to support the move, Rose attempted to purchase the relevant servicing rights himself to have the servicing moved over to his own shop; allegedly, Rose could not secure enough financing to manage such a purchase, and filed suit shortly thereafter.

O’Shea, Carrington’s attorney, says financing wasn’t the issue, and contends that AHMSI didn’t offer terms that were acceptable to Carrington to purchase the servicing. He also says that the hedge fund has ample room in its own credit facility to buy the servicing rights, if it wanted to.

Carrington’s complaint did not peg an alleged monetary damage suffered by the hedge fund, nor did the fund attempt to file an injunction to stop AHMSI from selling further REO properties tied to the contested securities. O’Shea told HousingWire his client has lost $128 million thus far on forced REO sales – all of the original principal amount invested. Of course, whether Carrington would have such broad rights as a junior bondholder to direct both the pricing and disposition methods of REO properties is a matter yet to be sorted out by the courts.

Both sides say they expect a long fight.

O’Shea told HousingWire that he believes according to the pooling and servicing agreement, AHMSI was required to uphold Carrington’s ‘special rights,’ as a responsibility to all investors. “They did it for the first few months, why aren’t they doing it now?” he said.

AHMSI’s Friedman told HousingWire that the servicer plans a fight of its own. “We plan to vigorously defend Carrington’s baseless claims in a court of law,” he said. “The servicer stands by the fact their real responsibility is to not violate its contractual obligations of the trust, and do right by all investors, not just the ones conveniently holding the ‘special rights.’”